Because yet another agreement for a temporary bailout of Spain will do little to address Spain’s real problems, which are its massively insolvent banks, its uncompetitive economy, and the fact that the country is caught in the downward spiral typical of debt crises in which every sector of the economy, not least its political elite, are acting in ways that systematically undermine growth and creditworthiness. The continued deterioration in Spain and elsewhere is now part of a fairly mechanical process that operates under its own dynamic, and it will take a lot more than exhortations to reverse the process

Unfortunately there isn’t much that can be done in a big enough or credible enough way to reverse the downward spiral, and this is why I don’t pay too much attention any more to the proposals and counterproposals that are on offer in Europe. I think it is probably too late for that, but certainly by continuing to behave as if this is all about trust, or lack of trust (or, for the more conspiratorially minded, about underhanded actions by speculators hoping to bring the system down), policymakers are building in their own disappointment and extending the crisis.

At this point the only thing that can save the euro is a combination of moves in which the European banks are guaranteed by a credible institution and in which Germany takes steps to stimulate its economy quickly and dramatically. Until Germany is willing to boost domestic spending enough to run a deficit that allows Spain to run a surplus, it is impossible for Spain to repay its debt. This is just basic balance-of-payments arithmetic.

Given all the excitement over the speed of the deterioration in European markets, I suppose we are going to see urgent new measures announced and a temporary respite in the crisis, but ultimately I think this will be little more than a blip on the way to sovereign debt restructuring and the break-up of the euro. Nothing has changed fundamentally in Europe in the past few weeks and there is no reason to assume that the crisis is on its way to being resolved.

Any attempt to predict the likelihood and extent of a breakdown in an economic system – country, region, or company – that starts only from the asset/operational side of the economic entity (what Galbraith refers to above as real economic activity), without taking into account the feedback mechanisms inherent in the relationship between the asset and liability sides, is pretty useless.

What’s more, the recent history of disturbances in that economic entity tells us nothing about the future impact of similar disturbances – as long as the balance sheet structure is changing, and as Galbraith reminds us, the lack of instability during previous disturbances will itself change the structure of the balance sheet. Stability is itself destabilizing, as Minsky warned us, because it changes the nature of the relationship between the two sides of the balance sheet.

This is what I referred to as an “inverted” capital structure in my 2002 book, The Volatility Machine. An inverted structure is the opposite of a hedged structure – when the asset/operational side of your balance sheet does well, your liability side also does well, but when the asset/operational side does badly, the liability side does too.

Inverted balance sheets exacerbate volatility – good times are automatically better than they otherwise would have been and bad times are automatically worse. Countries (or companies) with inverted balance sheets are more volatile than countries with hedged balance sheets, and unless you can get all your speculative bets right, this higher volatility lowers growth over the long term. Inverted balance sheets, I argued in my book, are one of the key differences between countries that are able to recover successfully from crisis and countries that aren’t, and I would propose that this may be one of the differences between countries that can escape the middle income trap and countries that can’t.

Or to take two more obvious examples, first, asset based lending – for example against real estate – is also a source of balance sheet inversion. When asset prices rise, the value of debt collateralizing the assets also rises, but when asset prices drop the debt becomes less credible and its implicit cost to the economy rises. Second, borrowing short term, or borrowing in a foreign currency, has the same risk profile. When the country is doing well, the real cost of short-term or foreign currency debt declines, only to surge when the economy gets into trouble.

Sometimes inverted capital structures are inevitable, but liability management consists, in my opinion, of identifying ways of eliminating inversion when you can and embedding as much hedged liability structures as you can, so as to make the overall economy less, not more, volatile. In the case of China, stockpiling commodities is exactly the wrong thing to do – but of course it is hard to convince anyone that this is the case when we are in the “good” part of the volatility cycle.

"The
ESM has financial resources amounting to €500 billion. Compare this with the
total government bonds outstanding of close to €2,000 billion in Italy and of about €800 billion in Spain and it is
immediately evident that the ESM will be unable to stem a crisis involving one
of these two countries, let alone the two countries together.

In
fact it is worse. As soon as the ESM starts intervening, it will quickly
destabilise the government bond markets in these two countries. The reason is
the following.

Suppose
a new movement of fear and panic, triggered for example by the deepening
recession in Spain,
pushes up the Spanish government bond rate again.

At
the end of the operation it will be clear for everybody that the ESM has seen
its resources decline from €500 billion to €300 billion. Less will be
left over to face new crises.

Investors will start forecasting
the moment when the ESM will run out of cash.

They
will then do what one expects from clever people.

They will sell bonds now rather
than later.

The
reason is not difficult to see. Anticipating the moment the ESM runs out of
cash forcing it to stop its intervention, they expect bond prices to crash. To
prevent making large losses, they will have an incentive to bring their bond
sales forward to the present rather than wait until the losses are incurred.
Thus the interventions by the ESM will trigger crises rather than avoid them.

This
feature is well-known from the literature on foreign exchange crises. The
classic Krugman model, for example, has the same features (Krugman 1969, see
also Obstfeld 1994). A central bank that pegs the exchange rate and has a
finite stock of international reserves to defend its currency against
speculative attacks faces the same problem. At some point, the stock of
reserves is depleted and the central bank has to stop defending the currency.
Speculators do not wait for that moment to happen. They set in motion their
speculative sales of the currency much before the moment of depletion,
triggering a self-fulfilling crisis.

Only the ECB can stabilise
bond markets

The
only way to stabilise the government bond markets is to involve the ECB, either
indirectly by giving a banking license to the ESM so that it can draw on the
resources of the ECB (see Gros and Mayer 2010), or by direct interventions by
the ECB. But the European leaders were unable (unwilling) to take that necessary
step to stabilise the Eurozone.

The
ECB is the only institution that can prevent panic in the sovereign bond
markets from pushing countries into a bad equilibrium, because as a
money-creating institution it has an infinite capacity to buy government bonds.
The fact that resources are infinite is key to be able to stabilise bond rates.
It is the only way to gain credibility in the market.

The SMP is the wrong
precedent

The
ECB did buy government bond markets last year in the framework of its
Securities Markets Programme (SMP). However it structured this programme in the
worst possible way. By announcing it would be limited in size and time, it
mimicked the fatal problem of an institution that has limited resources. No
wonder that strategy did not work.

The
only strategy that can work is the one that puts the fact that the ECB has
unlimited resources at the core of that strategy. Thus, the ECB should announce
a cap on the spreads of the Spanish and Italian government bonds, say of 300
basis points. Such an announcement is fully credible if the ECB is committed to
use all its firepower, which is infinite, to achieve this target.

If
the ECB achieves this credibility it creates an interesting investment
opportunity for investors. The latter obtain a premium on their Spanish and
Italian government bond holdings, while the ECB guarantees that there is a
floor below which the bond prices will not fall. (The floor price is the
counterpart of the interest rate cap). In addition, the 300 basis points acts
as a penalty rate for the Spanish and Italian governments giving them
incentives to reduce their debt levels.

The
ECB is unwilling to stabilise financial markets this way. Many arguments have
been given why the ECB should not be a lender of last resort in the government
bond markets. Many of them are phony (see De Grauwe 2011, Wyplosz 2011). Some
are serious like the moral hazard risk. The latter, however, should be taken
care of by separate institutions aimed at controlling excessive government
debts and deficits. These are in the process of being set up (European
Semester, Fiscal Pact, automatic sanctions, etc.). This disciplining and
sanctioning mechanism should then relieve the ECB of its fears of moral hazard
(a fear it did not have when it provided €1,000 billion to banks at a low
interest rate).

(...)

What should be done?

The
correct business model for the ECB is one that has it pursuing financial
stability as its primary objective (together with price stability), even if
that leads to losses. There is no limit to the size of the losses a central
bank can bear, except the one that is imposed by its commitment to maintain
price stability. In the present situation the ECB is far from this limit (Buiter
2008).

"Putting the ECB in
charge of banking supervision thus solves one problem. But it creates
another one. Can one still hold national authorities responsible for
saving banks which they no longer supervise?

This is not a new
problem. The De Larosiere Report (2009), which became the basis for the
creation of the European Banking Authority (EBA) and the Systemic Risk
Board (ESRB), argued that the ECB should not be involved in ‘micro’
supervision mainly because banking rescue and resolution involves tax
payer money, which they assumed had to be national.

First comes EZ bank regulation then comes EZ bank rescues

Banking regulation
and restitution are difficult to separate – no wants to pay for things
they cannot control. Economic (and political) logic thus requires that
the Eurozone will soon need also a common bank rescue fund.

Officially this is
not fully acknowledged yet, except for a hint in the EZ summit statement
of June 28/9 which says that once a system of supervision involving the
ECB has been created it would become possible for the permanent rescue
fund, the ESM, to inject capital into banks.

This is how
European integration often advances. An incomplete step in one area
later requires further integration in related areas. In the past this
method has worked well. The EU of today is a result of such a process.
But a financial crisis does not give policymakers the time they used to
have to explain things to their electorate. The steps will have to
follow each other much more quickly if the euro is to survive in its
current form.

Problems ahead

The worrying thing
is that the terrain EZ leaders must cross is heavily mined. Europe does
not have the luxury to construct its banking union from a stable
situation. This new institution is being set up in the midst of a
banking crisis.

There are clearly large losses that have to be realized and allocated.

This means serious distributional conflicts both within and between member countries.

The most difficult
case is going to be Spain. The local savings banks are the weakest part
of the Spanish banking system because they specialized in mortgages and
lending to developers, i.e. the areas where very large losses are to be
expected. A number of these were recently 'privatized', often in the
context of mergers. These new institutions then had to raise capital in
various forms (shares, preferred shares, subordinated debt).

Given that
institutional and especially international investors were not willing to
invest in these instruments (not surprising given that the state of the
Spanish real estate market) the new capital was raised mainly from
domestic investors, often the depositors themselves.

Who pays for past mistakes?

This leads to the first conflict: Who should bear the losses the (Spanish) investors or the Spanish government?

As retail investors
are also voters, the government (and the management of the cajas) have
now incentives to pay back as quickly as possible all instruments that
would otherwise be loss absorbing. This seems to be happening on a broad
scale. It is
thus possible that by the end of this year the weakest banks will have
repaid all of their hybrid instruments at par or close to par. At that
point the loss absorption capacity of the Spanish banking sector will be
much reduced.

But this leads to the second distributional conflict: Will the European tax payers want to pay for past losses? As
the answer is presumably no, there is thus a danger that by the end of
this year it will become impossible to inject European capital into
Spanish banks unless either a number of banks have gone into informal
insolvency (to bail in other creditors) or the Spanish government has
put enough into the system to cover past losses (which it might not be
able to do). The road towards banking union is going to be difficult."

" The European leaders this time have offered a more hopeful approach than
in the past in both form and substance, but Europe could still be
headed in the wrong direction unless the ECB builds an appropriate
bridge on the structure of the decisions taken at the June summit and
the political process implements those decisions comprehensively and
expeditiously."

Some private unofficial estimates put the potential losses of Finland
with continued EZ membership at between 10 and 15% of Finnish GDP.

Fourth, many social, business and political forces in Finland are
skeptical of the euro and/or supportive of an exit. The most fervent
euro-skeptic group is The Finns Party (formerly the “True Finns”). But
even the broadly pro-euro National Coalition, the party of the current
prime minister, contains opponents to the common currency, one of which
is Finland’s President, Sauli Niinistö, who bemoans the fact that
Finland bails out richer EZ members, yet is still pro-euro. Another
party leader, Ben Zyskowicz, last week pointed out the EZ’s fundamental
design flaws. For the time being, the forces formally supporting a
“Fixit” are in the minority, but there is now significant internal
debate on the pros and cons of membership. If Greece moves closer to
exit and Italy and Spain end up on the verge of losing market access and
requiring even more risky financial support from the EZ core, Finland
may decide that the additional credit risk is not worth the benefit.
Indeed, the country has already been the most vocal so far—in debates
about the EFSF, the ESM and other aspects of the periphery bailouts—in
requesting formal collateral or seniority for its contributions to the
EZ periphery rescues.

For now, the ruling coalition is still firmly in support of EZ
membership, but there are plenty in favor of an exit in the political
opposition; even within the coalition, many are grumbling in private
about the costs of EZ membership. A trigger to increase the chances of
Fixit would be a decision by the EZ to increase the potential losses and
credit risk of the core members—including Finland’s—via a fiscal and
transfer union, debt mutualization and EZ-wide deposit insurance. At
that point, the forces pushing for Fixit may get the upper hand.

The Affordable Care Act is constitutional in
part and unconstitutional in part. The individual mandate cannot be upheld as
an exercise of Congress’s power under the Commerce Clause. That Clause
authorizes Congress to regulate interstate commerce, not to order individuals
to engage in it. In this case, however, it is reasonable to construe what
Congress has done as increasing taxes on those who have a certain amount of
income, but choose to go without health insurance. Such legislation is within
Congress’s power to tax.

As for the Medicaid expansion, that portion of
the Affordable Care Act violates the Constitution by threatening existing
Medicaid funding. Congress has no authority to order the States to regulate
according to its instructions. Congress may offer the States grants and require
the States to comply with accompanying conditions, but the States must have a
genuine choice whether to accept the offer.[45]

[ . . . ]

The Federal Government does not have the power
to order people to buy health insurance. Section 5000A [of the Internal
Revenue Code] would therefore be unconstitutional if read as a command. The
Federal Government does have the power to impose a tax on those
without health insurance. Section 5000A is therefore constitutional, because it
can reasonably be read as a tax.[46]

Justices Scalia, Kennedy,
Thomas, and Alito signed a joint dissent in which they argued that the
individual mandate was unconstitutional because it represented an attempt by
Congress to regulate beyond its power under the Commerce Clause.[49] Further, they argued that
reclassifying the Individual Mandate as a tax rather than a penalty in order to
sustain its constitutionality was not to interpret the statute but to re-write
it, which they deemed a troubling exercise of judicial power.[50]

There was speculation that
the joint dissent was the original internal majority opinion, and that Chief
Justice Roberts' vote changed some time between March and the public issuance
of the decision.[51][52][53] Paul Campos, a professor of law at
the University of Colorado at Boulder, for example, quotes the following
passage from the joint dissent:[51]

Finally, we
must observe that rewriting §5000A as a tax in order to sustain its
constitutionality would force us to confront a difficult constitutional
question: whether this is a direct tax that must be apportioned among the
States according to their population. Art. I, §9, cl. 4. Perhaps it is not (we
have no need to address the point); but the meaning of the Direct Tax Clause is
famously unclear, and its application here is a question of first impression
that deserves more thoughtful consideration.

Campos then concludes that: "The dissenters are saying that construing
the mandate as a tax would require them to address a constitutional question
that they don’t have to address. But the only reason the Court would not have
to address this question is if the majority in fact refused to construe the
mandate as a tax – which is exactly what the Court’s majority ended up doing.